DOMESTIC AND FOREIGN EFFECTS ON PRICES IN AN OPEN-ECONOMY - THE CASE OF DENMARK

Domestic price determination in Denmark is investigated using three kinds of macroeconomic explanations: (1) internal labor market theories describing the relation between price and wage inflation, (2) pure monetarist theories describing the effect of excess money on the inflation rate, and (3) external theories describing the foreign transmission effects on a small open economy. The empirical analysis makes use of the multivariate cointegration model, which is based on the joint analysis of long-and short-run behavior. The deviations from derived underlying steady states in each sector were found to be the main determinants of the inflation rate. Among these, the domestic effects were small compared to the foreign effects. The empirical results strongly favored a backward-looking behavioral model in terms of structurally stable parameters as opposed to a forward-looking expectations model. The results stand up as quite strong evidence against the Lucas critique.